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Tuesday, December 13, 2016

Key Points to Watch in Wednesday's FOMC Announcement

As of today's market close, the 30-day Fed Funds Futures have factored in a 95.4% probability of a .25 bps increase in interest rates when the Federal Open Markets Committee (FOMC) releases their December announcement at 14:00 EST on Wednesday. This would mark the first rate hike since December of last year, and it would raise the Fed Funds rate to a target range of 0.50% to 0.75%. The market would then settle rates around 0.63%, up from the current 0.38%. The equities market expects the rate increase and has largely included it in stock prices.

The actual monetary policy move is of little substance, tomorrow. What traders and investors will be watching is the tone of the monetary policy announcement coupled with the statements and responses Janet Yellen provides in the post-announcement press conference. That tone and her responses may significantly move the market heading into tomorrow's close. Here are some points that we are watching.

Commentary regarding unemployment. The most popular number watched by the press and typically referenced by Yellen is the U-3 number which currently sits at 4.6%. We know that she will reference that number and will likely cite it as an indication that the nation is at "full employment." In past conferences, however, she has also made passing reference to both the U-6 number (9.3%) and to the Civilian Labor Force Participation Rate (62.7%.) Those numbers paint a less rosy picture of the employment situation and we'll be watching how Yellen presents either of them in her commentary.

The next major number we expect the Fed Chair to reference is the Inflation number. It currently sits at 1.64%, slightly below the Fed target of 2.0%. Since changes to monetary policy typically take approximately 6-months to have and effect, it's no surprise that the Fed will move ahead of their target. It's like turning an ocean liner - it takes time to get the behemoth pointing in the right direction. What we will be watching, however, is her assessment on the rate at which she expects inflation to increase. This will offer some guidance as to how quickly rates will be increased in 2017.

We anticipate some commentary, at least in the press conference, regarding potential tax and regulatory changes from the incoming Congress and Administration. A somewhat adversarial relationship is developing between the President-Elect and the Fed Chair, and the latter has expressed concern in recent weeks over the possible inflationary impact the theoretical domestic policy changes will have on our overall economy. How she references this and the tone she takes will provide more clues into how swiftly the Fed believes they must move in raising interest rates.

Some reference to "global economic headwinds" will likely be made, and that will most likely occur in both the announcement and in the press conference. What we will be watching is whether those headwinds are perceived to be holding steady, increasing, or decreasing. She may put this in the perspective of Brexit as well as the recent ECB announcement. In the past, the economic conditions in Europe have caused the Fed to take a more cautious approach domestically. Any improvement in the Fed's perception of those conditions will potentially signal a more hawkish economic policy in the US.

We must pay careful attention to the phrasing of certain terms. Once we have the announcement in hand, we need to compare the exact wording with the prior announcement. Dropping a single word in a phrase can signal a fundamental shift in outlook, so we will need to scrutinize any changes to prior announcement specific to the rate at which the economy is expected to grow.

Current market expectations are for two rate increases in 2017. These will most likely come in June and December. At least, that's what the Fed Funds Futures have currently factored into pricing. From a trading perspective, that is what we are attempting to anticipate. A more aggressive monetary policy may signal a potential rate increase in the February or March time-frame, and we'll see stocks react accordingly. Given the current inflation and unemployment levels, it's highly unlikely that the Fed will signal a slower rate of increase, although that more aggressive posture is a distinct possibility.

The final major consideration is something that will not be referenced in tomorrow's announcement, however it's something the markets will have to factor into pricing over the course of the next month. There are currently two vacancies on the Fed's Board. These will be filled by the President-Elect, and he will have the ability to make those appointments immediately following his inauguration. Given that he has already expressed displeasure with the dovish policies set forth by Yellen, it's almost a given that his two appointments will have a hawkish outlook. Their presence on the board will increase the likelihood of a more rapid normalization of interest rates than we've experienced thus far. Expect this to be factored into market pricing the closer we get to the inauguration.